By encouraging consumers to borrow and spend, rather than save, the US govt is taking on a huge risk
"Well I really love the coffee you make," I replied, rather matter-of-factly.
"Oh. I did not mean that. You know the United States has been trying for sometime to get its banks to lend and its citizens to borrow again. Don't you think that's kind of stupid?"
"Why do you say that?"
"Well, didn't excess borrowing cause the problems in the first place? Interest rates were low, which encouraged banks to lend more and people to borrow more. The borrowed money was used to buy homes, cars and other stuff. In case of homes, as home loans were easily available, more and more people borrowed to buy homes. Since demand was greater than the supply of new homes, prices started to shoot up. This encouraged even more people to buy and so the cycle continued. Banks did not keep the loans on their books. They converted these loans into financial securities and sold them to investors for a commission. Every time the borrower repaid the loan through an equated monthly instalment, a major part was passed on to the investor. That's how the investor made his money. And everybody was happy. Then, interest rates started to go up, and many of those who had borrowed beyond their capacity to repay started to default on their EMIs. When that happened, those who had invested in financial securities stopped getting repaid as well and so the crisis snowballed. Soon enough, the defaults had spread to credit card and auto loans too."
"I know all that. What's the point?
"Oh, don't you get it? In 1980, the US national debt was $930 billion, amounting to nearly a third of the country's gross domestic product (GDP). Today, the US national debt is $10.7 trillion, a little over three-fourth of the US GDP. The average debt on credit cards is currently around $16,600. With all the increased borrowing, the personal savings rate fell from 12% of the income earned in the early 1980s to -1% in 2006. Over the last few months, it has come into positive territory again, and is currently at 2%. And why is the savings rate in the positive territory again, if I may ask?"
"That's simple. People are spending less and trying to pay off the debt that they taken, which I feel is the sensible thing to do."
"Yeah, but what is that doing?" she asked.
"You tell me, since you seem to have figured this entire thing out."
"It is slowing down the economy. The aggregate demand or GDP of any particular country is made of four distinct elements and can be represented in equation form as Y = C + I + G + NX, where C stands for private consumption or money that you and I spend on buying goods and availing services; I stands for investment made by the private sector in setting up factories or any other thing that helps in producing stuff that can be consumed in future; G stands for government spending; and NX is the difference between exports and imports, assuming the money earned through exports comes back into the country and the money spent on imports leaves the country."
"Where are we headed?"
"Patience. In case of the US, private consumption accounts for 72% of the GDP. Now, when banks stop lending and people stop borrowing, the private consumption goes down. People don't buy homes, cars or other stuff. When private consumption goes down, the aggregate demand or GDP goes down. As you would know by now, the last two quarters have seen the US GDP shrink, which means the US economy is in a recession. When that happens, companies suffer because they earn less and then they go about firing their employees.
Now, an employee who has been fired will hold on to whatever money he has rather than go and buy things. And so the cycle continues. And what is the US government trying to do in order to break this cycle?" she asked.
"The US government is spending a lot of money and at the same time trying to ensure that people start borrowing again, for only if they borrow will they go out and buy things. This in turn will revive private consumption. And that you say is getting into dangerous territory."
"The right thing to do for Americans right now would be to reduce spending, save money and try and pay off as much debt as they can. But the government is trying to dissuade them from doing so because it impacts immediate growth. It wants them to borrow more and spend their way out of trouble," she explained.
"I get it now. The trouble with trying to spend your way out of trouble is that you will have to keep spending, much like a Ponzi scheme, which is a type of investment fraud where there is no business model in place and older investors are paid using the money brought in by new investors. The Ponzi scheme keeps running as long as the money being brought in by new investors is greater than the money needed to pay off older ones. Similarly, Americans will need to keep taking on more and more debt in the days to come in order to keep spending more, so the economy keeps growing."
"And as we know all too well, Ponzi schemes go bust one day," she quipped. "The US may be headed that way."
(The example is hypothetical)
References: 'Turning Japanese -The Audacity of Reality' by James Quinn, January 28, 2009, ww.dollarcollapse.com; 'Inflationism: The Bane of Capitalism', Doug Noland, January 29, 2009,www.prudentbear.com.
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